Drucker

[tweetmeme source=”pricingright”]As the economy continues to remain slow and businesses struggle to keep afloat many may be tempted to focus on volume and market share and dedicate all their resources to keep these numbers high at the expense of profit. Unless the business is in the early stage of its life cycle or relies on network effects the focus should be on profit.

We learn a valuable lesson from CPG companies that are relentlessly focused on profits at the expense of market share as they face cost conscious customers and renewed threat from private labels. Despite the recession, most CPG companies reported 10-14% profit growth. What these companies are practicing is Effective Price Management. Their methods apply not only to B2C but also to B2B companies.

I see three components that support effective price management. This article is somewhat inspired by Peter Drucker’s Five Deadly Business Sins and influenced by a recent article on pricing titled Eight Deadly Sins by James Mason in ICIS. I am very reluctant to use adjectives like ‘deadly’ or moralistic language like ‘sin’. So I decided to focus this article on what businesses need to change to practice effective price management.

Understand and quantify the value added to different customer segments: Costs do not matter, both for pricing and to the customers. Customers are driven by the value added by the product and this value-add differs for each segment. Businesses need to realize that their product lines, despite being homogeneous, add different value to different customers. They not only need to understand but also quantify customer value for different segments. Quantifying the value helps capture some of the value created – typically a business can capture only 10-20% of value created because of reference price and alternatives available to customers.

Every change needs an incremental analysis: Be it changes to pricing, adding capacity, changes to marketing budget or to sales team – do the analysis to find what it would do the current profit? How much incremental new sales is needed to just get back to current profit levels? (this is called incremental break even). Sales team is more than likely to push for price reductions but by how much will the sales go up, what is the price elasticity of the product? The operations team may push for adding capacity, the usual mistake is to treat this new investment as part of the rest of the cost structure, but you should exercise care in finding the true incremental profit from additional units sold from this newly added capacity.

Focus on the total margin per customer: A business should not just look at margins per product line – it needs to look at what is the total revenue including complementary sales and the total cost per customer. A product line may not by itself drive profits but can generate complementary sales that can all add up. The other factor in the profit equation is cost, the cost of serving the customers is not all the same – the costs cannot be clumped together as an average. Knowing the cost to serve a customer will help the business decide the level of service to provide and determine whether or not that customer is profitable. Classify the customer into Gold, Silver, Bronze etc based on their customer margin – keeping the top customers (i.e., those that generate more profit because they buy more and cost less to sell to) happy is going to be more profitable than acquiring new customers.

In future posts I will elaborate on many of the points I state here and provide examples.